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Saturday, September 29, 2007

Rockin' and Rollin' -- When to 'Roll Up' a Covered Call Position

Once a covered call position is established, one approach to managing that position is to simply “do nothing” until the expiration date. At expiration, one of two possible events occurs: (1) The stock price is above the option’s strike price (in-the-money) and the stock is ‘called away’ or ‘assigned’ (i.e. sold); or (2) the stock price is below the strike price, so the option ‘expires’ worthless and the stock position is retained. A ‘do nothing’ approach is often the best method for a covered call position and is normally an appropriate decision for the majority of covered call positions. However, there are some circumstances when it is preferable to manage (i.e. modify) the position before the expiration date. This modification is an opportunity to further enhance the potential return on investment that would otherwise be achieved by simply holding the initial position until expiration.

First, let’s make sure we have a common understanding of exactly what a roll up is. Paul Kadavy gives a nice explanation in his book ‘Covered Call Writing With ETFs’ where he describes the process of rolling up: “to buy back the first call options and then write new calls with a higher strike price.” I would add a short phrase at the end of that definition, namely ‘with the same expiration month’.

Before examining a specific example of a roll up, let’s mention some other examples of covered calls position management before expiration. This will help us to understand the the roll up within a broader context of the numerous position management (prior to expiration) alternatives. On page 70 of ‘New Insights on Covered Call Writing’ by Lehman and McMillan, they succinctly define the relevant terms:
Rolling: The process of closing the short call position in a covered write and opening (substituting) a different covered call position on the same stock.
Rolling Up: Substituting a call with a higher strike price.
Rolling Down: Substituting a call with a lower strike price.
Rolling Out: Substituting a call with a more distant expiration.”
An additional example would be ‘rolling up and out’, which would be the combination of simultaneously ‘rolling up’ and ‘rolling out’ -- for example, ‘rolling up and out’ from the XYZ Oct07 50s to the XYZ Nov07 55s. We will discuss these position management techniques in the future. For now, we will analyze only the rolling up case.

Let’s consider the Honeywell roll up done in the Covered Calls Advisor Portfolio as summarized in the previous post on this blog. In short, 500 shares of Honeywell (HON) were purchased on 9/10/07 at $54.23 and 5 Oct07 55 calls were sold at $1.80. When this covered call position was rolled up on 9/26/07, the stock had risen to $59.26 and the option to $4.70. Now the key question is: Should the existing position be kept until expiration or should it be rolled up to a higher strike price?

How should we analyze this decision? The key to understanding the answer is in the concept referred to as a ‘sunk cost’. A sunk cost is simply a cost that has already been incurred. It’s past. It’s history. So let’s consider our choices in the context of the HON example. First, disregard what happened between the time we initiated the covered call on 9/10/07 and today (we’ll pretend it’s now 9/26/07 for this example). The 68.5% annualized return achieved in the HON cc between 9/10 and 9/26 is now history; it’s a sunk cost (albeit a very profitable one). Nevertheless, what has already happened is meaningless in analyzing what we should do today (9/26) going forward.
Let’s compare two alternatives: (1) Do nothing. Keep the 500 HON shares and keep the 5 short Oct07 55s; or (2) Roll up. Keep the 500 HON shares and substitute 5 short Oct07 60 calls for the current 5 short Oct07 55 calls.
Here’s the key: Analyze the two option position alternatives as if you don’t already have a short options position.
Given that you already own 500 shares of HON at $59.26, would you prefer for the time period between now (9/26/07) and October expiration (10/20/07) to sell 5 Oct 55 options (priced at $4.70 on 9/26/07) or 5 Oct 60 options (priced at $1.10 on 9/26/07)? The primary factors for the two alternatives are as follows:
(1) For the Oct 55s:
Annualized Return If Unchanged (ARIU) = 11.3%
Annualized Return If Exercised (ARIE) = 11.3%
Downside Breakeven Protection = 7.9%
(2) For the Oct 60s:
Annualized Return If Unchanged (ARIU) = 28.2%
Annualized Return If Exercised (ARIE) = 47.2%
Downside Breakeven Protection = 1.9%
So which do you prefer? This advisor’s own personal guideline is to roll up to the higher strike price if two conditions are met: (1) The ARIU is more than 15% greater for the new position [in this case it was 16.9% higher (28.2%-11.3%)]; and (2) The per-day downside protection is >.06% [in this case it was .08% (1.9%/24 days until expiration)].
Your own criteria for an advantageous roll up might well be different than the 15% and .06% per day thresholds used by the Covered Calls Advisor.

Or perhaps your eyes are glazing over right now. You would really prefer an easier-to-apply guideline on when to roll up. If that is the case, I’d suggest using the ‘net debit to strike difference ratio’ as explained in the previous post on the HON roll up. There the guideline is: Roll up only if the ‘net debit to strike difference ratio’ is <75%. This analytical approach is definitely much less cumbersome than the more detailed approach described above, but it can be used with confidence since the resulting decision will be very comparable to that achieved by the more detailed method.

So, don’t be a ‘do nothing’. Start ‘Rockin and Rollin’ !!

Regards and Godspeed

6 comments:

  1. You took a $1,450 loss on your Oct 55 call then collected $550 on your Oct 60 call. If your Oct 60 expires worthless you're down $900. How is this better than letting the Oct 55 get assigned and making $1,285?

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  2. You are correct about the net profit of $1,285 if assigned at $55 strike. However, by rolling up to the $60 strike, the net profit will be $1,550 if assigned. This is an additional $265 ($1,550-$1,285) net profit resulting from roll up to the $60 strike.

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  3. ...and if you're not assigned?

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  4. Results vary depending on closing price of HON on expiration Friday (10/19/07).

    ReplyDelete
  5. Ok, lets say it's $55.

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  6. Does this clarify?

    BTO HON @ 54.23
    STO Oct55 @ 1.80
    Called = 55 - 54.23 + 1.80 = 2.57
    Expired = 1.80

    BTC Oct55 @ 4.70
    STO Oct60 @ 1.10
    Called = 60 - 54.23 + 1.80 - 4.70 + 1.10 = 3.97
    Expired = 1.80 - 4.70 + 1.10 = (1.80)

    ReplyDelete